Summer Bodysuit Ltd - Financing Dilemma - Essay Example

Report – SLA Ltd To The Board of Directors Summer Bodysuit Ltd Introduction This report would analyse the problems faced by the company and a comprehensive recommendation would also be provided to address the issues prevailing within the company. Summer Bodysuit Ltd.’s financing dilemma would also be addressed within the report and an appropriate action would also be put forward for the company to adopt in order to get the issue resolved. The fundamental way through which the entire issue is addressed is by first analysing the positives of the company by comparing its financial performance in the recently ended year to that of the previously finished year. The comparison would help in assessing the performance of the company within the two periods and would help in pin-pointing the areas which need proper attention from SBL’s management. Following the analysis of SBL’s financial performance and after addressing the problems face by SBL, a detailed plan of action would be recommended along with a formal conclusion that would augment the entire appraisal of the company’s performance The positives for SBL An independent review carried out by members of our company (Drake Management Consultants) reflected that SBL’s financial problems have improved in the recent ending year as compared to the prior year, with respect to profitability. The company improved on its profitability and this was assessed by using the profitability ratios. The main aim of profitability ratios is to analyse the efficiency of a company’s operations and the policies that the company has abided by in order to achieve the recent financial performance displayed within the financial statements. As per the profitability ratios, the performance of SBL has been exquisite. The profitability ratios clearly suggest that the company has improved their profit figure as compared to the year preceding the recently ended year. The company’s Gross Profit Margin and its Net Profit Margin have improved by 1.7% and 4.1% respectively. SBL has been able to control its cost within the two years with special focus within the recently ended year. The company’s Cost of Sales as a percentage of its sales are 53.5% and 51.8% in both the years respectively, showing a great improvement within the company’s ability to restrain its cost even when the revenue is increasing. SBL has also restricted and brought down their operating expenses with their revenue increasing. The operating expenses as a percentage of sales have been 31.5% (Year before last) and 27.6% (Last year) (Tyran, 1993). SBL’s return on its investment i.e. the profit that it has been able to generate from its assets has been seeing improving results when comparing the two years. SBL’s return on equity has also improved by more than double to what it was in the year before last. Now this is something that can be used to persuade investors towards investing money within the company. The profitability improvements should also be considered something fruitful for the company’s current owners and its employees as a sign of growth and as an indication of growth for the company. The other positive aspect for SBL is it improved Interest Cover ratio. The company has improved on its ability to pay off its interest and that too can be attributed to the improved profits that the company has been able to generate in the recent years (Financial Management, 2000). Problems faced by SBL After appraising the positives for SBL, a general evaluation of the problems faced by the company was carried out. The company has been found to be lagging behind when assessing its liquidity ratios in the two prior years. This deterioration is alarming for the company since it can lead the company towards bankruptcy. Besides the liquidity issue, the financial leverage for SBL is yet another issue which is rather agonizing for the company. As per the financial leverage ratios, SBL has gotten itself a heavy load of debt finance in order to run the operations of the business. According to the Debt-to-Equity ratio, SBL’s debt has moved almost double to its Equity finance, clearly indicating towards the recent injection of capital via debt within the company. The Debt to Equity ratio displays the company’s balance between its equitable source of finance and its debt. Huge debt financing leads the company to be referred as the highly geared while low debt financing addresses a company as a ‘low geared company’. The Debt to Equity Ratio states that SBL has obtained huge debt finance recently in order to run the operations of the company. The Debt to Total Assets ratio reflects the percentage of a company’s assets that are financed via debt. According to the ratios calculated above, more than half of the assets are financed via debt financing i.e. almost 63%. Total debt to total capitalization ratio illustrates the essence of long-term finance used as a way of financing a company. This ratio computes the proportion of a company's long-term debt and compares it to its available capital. By using this ratio, lenders identify the amount of leverage utilized by a specific company and compare it to others to help analyse the company's risk exposure in which they are investing. When a company depends heavily upon debt as a source of finance, the major issue that it ignites is the interest charge which needs to be paid off first before any other liability or dividend. Firstly, this enhanced debt finance would suppress the right of the shareholders to receive their dividend and finally upon bankruptcy, the company’s assets would have to be sold out to pay-off the debts before anything is distributed to the owners i.e. the shareholders of the company. Using debt finance as a source of capital has many other implications for a company too. Having too much debt jeopardizes a company’s ability to find alternate source of financing a company. Since when a company is highly geared, new investors would not be willing to invest or lend money to a company which is already laden with humongous debt as they would term this investment as a very risky venture (Acca, 2009). Nevertheless, if an investor agrees to lend some money to such highly geared company, it is bound to charge heavy interest rates because of the huge amount of risk that it would have to endure as a result of investing in the debt laden company and such is the scenario with SBL. SBL has been actively favouring debt finance and has recently used debt as the only source to finance the operations of the company. Such increased loans and the SBL’s failure to pay-off their loan commitments (when they fall due) has been one of the major point which would be of utmost importance when further finances for the company would be needed for the company. Though Equity finance can be a source of injecting capital within the company but the hurdle which may stop SBL to acquire equity finance includes the objection raised by the Keeble brothers against the introduction of any other equity shareholder since it would dilute their shareholding within the company (Bull, 2008). The Activity/Efficiency Ratios also highlight another issue which may be deterring SBL to perform at the paramount level. According to the efficiency ratios, the company has not performed efficiently as compared to the previous year and it has performed way below par within the recently ending year. SBL’s ability to recover its debts has deflated and its collections days have also increased in the recent year eyeing concern of cash being stuck with the receivables for too much period of time. As per the Receivable turnover ratios, the company’s receivable days has increased in the recent year suggesting that the company has tangled up its finances with their receivables rather than collecting them at appropriate time. SBL has also fallen behind with respect to its ability to sell of its inventory quickly and convert it into cash at a much quicker rate. SBL’s ability to sell off its goods has worsened from the previous year and that too at a much higher rate. This would certainly have a negative impact on the company as it would be needing finances from elsewhere to take care of the short fall in cash resulting from the entangling of cash within inventory. The company has also reduced its effectiveness with respect to its ability to utilize its assets to generate sales. This has been pointed out within the Asset Turnover ratio which clearly highlights the negative aspect of SBL’s under-utilization of their assets with respect to their sales (Shim et al, 2008). Detailed plan of action – 6 Month Plan The recommended plan that would suit SBL would firstly be to load-off some of its long-term debt by paying it off. This way the company would be able to gains a better gearing image as its current financing structure reflect SBL to be a highly geared company which would definitely not be able to gain any new loan/debt finance from any new potentials investors. Besides this, the company would also not be able to persuade anyone by offering the equity share capital because of this enhanced gearing structure. After unloading some off its loan and overdraft facility, the company would have find other suitable source to finance the company. As it would be really difficult to find any outside finance, the company would have to look up at the alternatives available within the company itself. The best inside source of finance available for the company would be to utilise its reserves i.e. its Retained profits. The company has been keen enough on saving huge amounts within its Retained profits and the excessive amount can be extracted to operate the company currently. Since the Keeble brothers are willing to sell of their holding within SBL, these Retained Earnings can be used to redeem the shares which they hold. Once the shares are bought back, the shares can be offered to other investors or can also be offered publicly through an Initial Public Offering, making the company a Public Limited Company. The share which would be re-launched for re-selling within the market would have to be offered at a premium in order to gain adequate equity finance to run the company smoothly (Berman et al, 2013). Another recommendation for SBL would be to improve its Working capital management in order to gain funds that would help the company in financing its day to day operations. SBL’s activity ratios clearly illustrate that the company is not operating to its optimum level and hence it should trade efficiently in order to gain quick finance from its operations. The best plan would be to improve the conversion of stock into cash i.e. by selling the inventories quickly and that too on cash basis. Whereby debtors or receivables are involved, SBL should try to recover the cash by the earliest possible time since a longer entanglement of cash with debtors would deprive SBL of the finance that it would be needing to smoothly run the operations of its company and SBL would have look for alternate sources of finance to take care of its business operations. Recovering cash from debtors may also need to be done carefully as it may dent a company’s image and might also result in reduced customers in the future. The best way to lure customers into paying quickly would be to offer incentives to customers such as early payment discounts or other gift vouchers whenever they pay quickly (Jain, 2004). Bank’s request for reduction The Bank’s request to significantly reduce the overdraft facility can be truly understood. There are a few reasons which may have prompted the bank to ask for a reduction in the overdraft facility. One of the reasons which might have led the Bank to call for such an action would have been that SBL had breached the overdraft limit numerous times and that the bank might have sniffed a default from SBL’s end. Breaching an overdraft limit may not be much of an issue if the act is committed rarely but frequent incidence of such breach would have led the Bank to re-consider their entire financing proposal primarily eyeing concerns of default from SBL. Besides the recurring breaches in the overdraft facility, SBL’s liquidity ratios are yet another measure that portrays negativity for both the bank and the company itself. The liquidity ratios for SBL evidently indicate that the company is falling back with respect to the liquidity ratios and that there are huge chances that the company may go redundant. Liquidity ratios are the main ratios that any investor scrutinises prior to approving any loan or investing within any company. The main area of concern for all investors is their money and since liquidity ratios display the solvency of a company, an investor hugely relies on them prior to making any investments. The liquidity ratios for SBL have deteriorated significantly and that has been hugely because of the overdraft facility. Though the company’s’ current assets are enough to pay-off its current liabilities, its liquid assets are not enough to take care of the short-term liabilities as soon as they fall due (Matz, 2011). The major issue with SBL has been its inventory which tangles up huge cash reserves of the company and the company is not able to sell off its goods and easily convert them into liquid cash. The aforementioned issues are certainly the major contributors which would have led the Bank to ask for the significant reduction in the overdraft facility and Bank’s concern is somewhat appropriate since it feels the risk of losing its money (Helfert, 1997). Conclusion After comprehensively analysing the entire situation of SBL, it can be easily concluded that the company has to offer huge prospects to its owners and its investors by providing them with the desired return that they all strive for. The only issue is that the company is not being steered properly since its lacks appropriate financial expertise and this vacuum should be filled by a proper hiring in the respective department. SBL should reduce its overdraft facility by paying it off either through the Retained Earnings or by issuing new share capital by redeeming the Keeble brothers’ shares. This reduction in the overdraft facility would also improve the company’s liquidity position along with it gearing position making it a more feasible investment for other prospective investors. From Ronald Henderson Drake Management Consultants List of Appendices Appendix A Liquidity Ratios Ratios Year before last Last Year Current Ratio 4356/2482 = 1.76 9974/8844 = 1.13 Quick Ratio (4356-2418)/2482 = 0.78 (9974-5820)/8844 = 0.47 The liquidity ratios suggest that the company’s liquidity position has worsened as compared to the prior year. Liquidity ratios are a measure of a company’s ability to pay off its current liabilities with that of its current assets. According to the ratios calculated above, the company’s liquidity has worsened in the recently ending year. The Current ratio and the Quick ratio have both deteriorated, causing concerns for the company (Matz, 2011). Appendix B Financial Leverage Ratios Ratios Year before last Last Year Debt-to-Equity 6082/6874 = 0.88 15444/9000 = 1.72 Debt-to-Total-Assets 6082/12956 = 0.47 15444/24444 = 0.63 Total Debt to Total Capitalization 6082/10474 = 0.58 15444/15600 = 0.99 Financial Leverage ratios provide an insight to the way through which a company is financed. The ratios indicate that the company has obtained a new loan more than double of the previous year’s debt as a method of financing the company. Appendix C Coverage Ratios Ratios Year before last Last year Interest Cover 2100/432 = 4.86 4618/912 = 5.16 Interest Cover has improved for SBL as it suggests that the company’s ability to pay off its interest payments via its profit has improved (Morley, 1985). Appendix D Activity Ratios Ratios Year before last Last year Receivable Turnover 14006/1614 = 8.68 22410/3744 = 5.99 Avg Receivable Collection Period 365/8.68 = 42 days 365/5.99 = 61 days Inventory Turnover 7496/2418 = 3.1 11618/5820 = 2.0 Inventory Days in Period 365/3.1 = 118 days 365/2.0 = 183 days Total Asset Turnover 14006/12956 = 1.08 22410/24444 = 0.92 Receivables Turnover suggests that the company’s performance with respect to its receivable collection ability has deteriorated over the two years. The Average Collection Period has also worsened for SBL. Inventory Turnover suggests how many times a company is able to sell of its inventory over a period of time and SBL’s performance with respect to Inventory turnover has depreciated when compared between the two years. The inventory days in period have also exceeded citing concerns for the company as it would need more time to sell of its inventory. Total Asset Turnover has also worsened for the company and has dropped from being 1.08 in the year before last to 0.92 in the last year (Jain, 2004). Appendix E Profitability Ratios Ratios Year before last Last year Gross Profit Margin 6510/14006 = 46.5% 10792/22410 = 48.2% Net Profit Margin 1248/14006 = 9% 2926/22410 = 13.1% Return on Investment 1248/12956 = 9.6% 2926/24444 = 12% Return on Equity 1248/6874 = 18.2% 2926/9000 = 32.5% The Gross Profit Margin has improved for SBL when comparing the two years under scrutiny. The Net Profit Margin and the Return on Investment has also improved for the company. The Return on Equity has also improved significantly for the company (Tyran, 1993). Works Cited Acca - F9 Financial Management: I-learn. Gardners Books, 2009. Print. Berman, Karen, Joe Knight, and John Case. Financial Intelligence: A Manager's Guide to Knowing What the Numbers Really Mean. Boston, Mass: Harvard Business Review Press, 2013. Print. Bull, Richard. Financial Ratios: How to Use Financial Ratios to Maximise Value and Success for Your Business. Amsterdam: CIMA, 2008. Print. Financial Management. Tampa, Fla: Financial Management Association International, 2000. Internet resource. Helfert, Erich A. Techniques of Financial Analysis. Chicago, IL: Irwin Professional, 1997. Print. Matz, Leonard M. Liquidity Risk Measurement and Management: Basel Iii and Beyond. Bloomington, IN: Xlibris Corp, 2011. Print. Jain, Narender K. Working Capital Management. New Delhi: A.P.H. Pub. Corp, 2004. Print. Morley, Michael S. Ratio Analysis. Wokingham: Van Nostrand Reinhold, 1985. Print. Shim, Jae K, and Joel G. Siegel. Financial Management. New York: Barron's, 2008. Print. Tyran, Michael R. Handbook of Business and Financial Ratios. New York: Woodhead Faulkner, 1993. Print. Read More